We are coming to the end of the Financing Options series. This is the final post in the series. Today we are going to talk about working capital financing.
For those of you not steeped in finance and accounting matters, I suggest you go back and read the Balance Sheet post before reading on. Working Capital Financing relies on a company’s balance sheet to support the loan so understanding how a balance sheet works is important to understanding working capital financing.
As a company grows, it starts to consume a lot of cash in the day to day operations of the business that has nothing to do with its profits or losses. This type of cash consumption is called working capital. In accounting terms, working capital is equal to current assets minus current liabilities. In layman’s terms, working capital is what your customers owe you plus any inventory you have built up minus what you owe your suppliers and employees. Working capital also includes any cash you have in the bank.
One of the many awesome things about a software business is that it rarely has any inventory. But for the purposes of this post, we need to think about a business that has inventory because inventory buildup is a big reason that companies consume working capital.
Let’s think about a company that makes iPad stands like this one (I have it, it’s awesome). Let’s say it costs $25 to manufacture one iPad stand. Let’s say you have orders for 10,000 of them at a wholesale price of $40. So you need to come up with $250,000 to produce the inventory to meet the demand. Then you ship the iPad stands to Amazon or some other retailer. And then you wait 60 to 90 days to get paid the $400,000 by that retailer.
On paper, your business looks great. You have revenues of $400,000 and costs of $250,000. You have profits of $150,000. But you cash situation is horrible. You are out $250,000 and you are going to wait 60 to 90 days to get the $400,000 from retail. And you’ve got another order but this time it is for 20,000 units. You need to come up with $500,000 to meet demand.
This is known as a working capital issue. The business is making plenty of money on paper but can’t manage its cash needs. And the faster it grows, the worse it gets.
This is exactly the situation working capital financing was designed to deal with. Banks and finance companies will loan companies, particularly profitable companies, the money they need to purchase inventory and wait to get paid by their customers. Banks will rely on the purchase orders on hand and the actual value of the inventory that the company has in stock to backup the loan. They will also take into account the money the company owes its suppliers and employees in determining exactly how much capital to loan the company.
Most working capital financing has built in cushions. Banks will not loan 100 cents on the dollar of working capital. They might loan 75% or 50%. But as working capital grows, they will increase the size of the loans they make. These are all short term loans because the inventory eventually gets sold and the customers eventually pay. A typical way these loans are structured are lines of credit and revolvers meaning that as the money comes back into the business, the loans get repaid, but the total amount available under the loan stays the same so the company can just borrow it back when it needs the money again.
For companies that are particularly shaky, there is a technique known as “factoring” where the bank actually takes the amounts of money due from the customers as collateral and gets paid directly by the customers and then remits the extra amounts to the company. The bank essentially becomes the accounts recievable department of the company. Back in the dark days in the aftermath of the crash of the internet bubble, I got a bank to do this for one of our portfolio companies and it was the only way we got through a major financial crisis.
Even a software based business can build up a lot of working capital. It ususally results from the company having to pay its obligations much faster than its customers are paying the company. If you have customers that pay in 90 days and you are growing revenues quickly, then you can find yourself in a major cash squeeze. Working capital financing is a great way to manage that kind of cash squeeze.
From the comments
Neil Kusens shared his story:
I grew an e-commerce startup from $0 to $30 mil in revenues in a few years using working capital loans among other financing tools – and came across every time of success and failure you can experience with these loans.
Some words of caution for the community here:
1) It might go without saying to most of you — but just in case — most of the time, the borrowing company will need to have some serious personal guarantors to back up these types of loans. Just looking at your purchaser orders (even if its from someone as well known as Amazon) won’t typically get you a working capital loan unless you are a very established company or are willing to pay ghastly interest rates! Typically, most companies that need this type of loan aren’t established, so all the main principals of the business will need to have excellent credit scores in order to secure these loans. And of course, if something bad happens, and you can’t make those repayments – you are personally on the hook.
2) When thinking about these types of loans, make sure you take every possible headache into consideration. In my naive days, I thought the formula was as simple as I was taught in business school (and summarized here by Fred). But there are all kinds of headaches involved here — especially on the A/R side. Some examples:
– if you are a young business and have a thousand pre-orders direct to consumers (not one big PO to Amazon in this example) – you are likely to be subjected to holds from your merchant processor in releasing your funds – without any notice in some cases. These holds can last 6-12 months. Depending on how good your personal credit is (again, your on the hook here with merchant processors too) and how itchy the merchant processing bank is, they might hold back 10% of all credit card funds in a reserve, or in some cases, much much more. Bottom line: it might take longer to get your funds than you think – and you better plan for this contingency!
– on the other hand, if you have one big PO from someone like Amazon, you might have other headaches. Not only might they slow pay you at 90 days, but they know how much power they wield as the primary retailer for a small up-and-coming business, and often times will demand better pricing terms after the PO is already placed and product was shipped. I’ve seen it happen plenty of times! (Also, they will often time demand you take back product if it hasn’t sold-through – ready your contract with them very carefully!)
I’ve got all kinds of other lovely war stories I could spend days typing about. In the end, these types of loans can go very wrong – so tread carefully!
This article was originally written by Fred Wilson on August 22, 2011 here.